Valuing Inventories

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Valuing Inventories

• Chapter Eight

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Chapter Eight Objectives

• Explain how merchandising and manufacturing
  companies value inventory and determine costs of
  goods sold.
• Understand the periodic and perpetual methods for
  recording inventory.
• Recognize the implications of alternative
  inventory costing methods for income measurement,
  cash flows, and asset valuation.
• Read and interpret inventory footnote disclosures.

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Inventories

• Goods that firms make or buy to sell to
  customers.
• Using accrual accounting, inventories are costs
  that will generate future revenue.
• We look at inventory from perspective of
• Merchandising firm buys completed product and
  sells to consumers
• Manufacturing firm makes products internally.

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Stages of Inventory

• Raw materials- goods that have not been put into
  manufacturing process.
• Work in process (WIP) - inventory that is
  partially processed and not complete.
• Finished goods- the completed product ready to be
  sold to customers.

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Valuing Inventory

• Firm records inventory on its balance sheet at
  the acquisition cost.
• GAAP requires that a firm value inventory of the
  lower of
• The cost value or
• Market value (the replacement cost or net
  realizable value).

For example Suppose Frames-For-You stocks new
picture frames costing 50M that it hopes to sell
for 90M. At the end of the year, management
finds that the amount that will be realized is
20M. It will have to book a loss of 30M.
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Inventory Costs

• For a merchandiser, inventory costs are the
  purchase price of the products and transportation
  costs.
• For the manufacturer
• Beginning inventory WIP
• Direct Labor costs incurred
• Direct Materials applied to production
• Factory OH costs incurred
• -Ending Inventory work in process
• Cost of Goods Manufactured

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Inventory Costs

• Now use Cost of Goods Manufactured
• Beginning Inventory Finished Goods
• Cost of Goods Manufactured
• -Ending Inventory Finished Goods
• Cost of Goods Sold
• Product costs directly or indirectly relate to
  manufacturing process and are capitalized.
• Fixed costs- do not change with the level of
  production.

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Accounting for Inventory
Inventory is an asset
It becomes a cost of goods sold - an expense!
Once it is sold.

• When a company allows returns it must be able
  estimate returns to recognize sales and expenses.
• Shrinkage is loss or waste of inventory and can
  be found from a physical count of goods.

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Methods for Recording Inventory

• Periodic method- inventory levels are checked
  periodically to determine what was sold and
  what remains.
• Perpetual method- every time an item is purchased
  or sold, the accounting records are updated.

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Periodic Inventory

• Use the equation to find the cost of inventory
  sold
• Advantages
• Very easy to use
• Low cost
• Disadvantages
• Does not provide a continuous record of sold
  inventory
• Inventory levels may fall very low before it is
  noticed that reorders need to be places.
• Lack of supply may lead to lost sales.

Beginning Inventory Purchases -Ending
Inventory Cost of Goods Sold
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Perpetual Method

• Using the bar code system, goods are tracked when
  purchased and when sold.
• Physical count is still performed to check for
  shrinkage.
• Using technology inventory levels are always
  known and reorders can be made efficiently.

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Cost Flow Assumptions

• Each unit sold must have a cost (what it was
  purchased or manufactured for) associated with it
  so the cost of goods sold can be reported.
• If all units are the same and there are no cost
  changes, then all inventory methods will result
  in identical costs.
• But, when purchase costs change, different
  inventory methods will result in different costs
  and different balance sheet amounts.

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Methods for Cost Flow

• First- In, First-Out (FIFO)
• Last-In, First-Out (LIFO)
• Weighted Average (WA)
• Specific Identification
• Each method can be used in a periodic or
  perpetual system

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FIFO

• Follows the physical flow of goods.
• The first products purchased/manufactured are the
  first products assumed to be sold.

Think of the milk on the shelves of the grocery
store. The first milk put on the shelves with
the expiration date that is approaching will be
in the front, where as the milk with a later
expiration date will be in the back.

• Thus the older purchase prices are used as the
  cost of the inventory sold (expense).
• The newer purchases will remain in inventory.

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LIFO

• Under this method it is assumed that the last
  inventory purchased is the first items sold.

This is similar to a candy jar. Whatever was the
last candy to be put into the jar will be the
first candy to be sold.

• The value of the last items purchased will be
  expensed, and the value of the older items will
  remain on the balance sheet.
• LIFOs main advantage is its tax implications.
• If LIFO is used for tax reporting it must also be
  used for financial reporting.

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Other Methods

• Weighted average averages the costs for
  reporting inventory and COGS.
• It is easy to use for companies who have low cost
  inventories.
• Specific Identification The cost of each unit is
  tracked until sold.
• It is used for high priced or unique products.

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Application Inventory Data
Date
Event
Units
/Units
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Periodic FIFO

• The first inventory purchased is the first sold
• Total units sold 30 65 95 units.
• COGS (70 x 100) (20 x 110)
• (5 x 145) 9,925
• Ending Inventory 40 units left in inventory at
  145 5,800.

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Periodic LIFO

• Using the same data
• The last inventory purchased is the first sold
• Total units sold 30 65 95 units.
• COGS (45 x 145) (20 x 110) (30 x 100)
  11,725.
• Ending Inventory 40 units left in inventory at
  100 4,000.

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Periodic Weighted Average

• The total cost of inventory
• (70 x 100) (20 x 110) (45 x 145)
• 15,725
• Total units on hand 70 20 45 135
• Average cost/unit 15,725 / 135 116.48
• COGS 95 units x 116.48 11,065.74
• Ending Inventory 40 units x
• 116.48 4,659

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Perpetual Calculations

• Perpetual FIFO results are the same as periodic
  FIFO.
• For LIFO COGS
• 4/14 Sale of 30 units 20 at 110 2,200
• 10 at 100 1,000
• Cost of sale 3,200
• 12/18 Sale of 65 units 45 at 145 6,525
• 20 at 100 2,000
• Cost of sale 8,525
• Total COGS (Cost of goods sold) 11,725
• For LIFO Ending Inventory 40 at 100 4,000

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Perpetual Calculations

• Perpetual Weighted Average Cost (WAC) for each
  sale
• For WA COGS
• Weighted average cost ((70x100)(20x110))/90
  102.22/unit
• 4/14 Sale of 30 at 102.22222 3,067
• Inventory left 60 x 102.226133.33
• Purchase 45 x 1456525
• Total 12,658.33 for 105 units
• New weighted average cost 120.55 unit
• 12/18 Sale of 65 units 65 x 120.55
• Weighted average ending inventory
• 40 x 120.55 4,822.

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Conclusions

• In rising prices FIFO has higher inventory on
  the balance sheet and lower COGS.
• This leads to higher income and higher taxes.
• LIFO has lower balance sheet inventory and higher
  COGS.
• The result is lower income and lower taxes.

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Question Time

•  During a period of rising prices, the inventory
  costing method that will result in the lowest
  amount of net income is
• LIFO
• FIFO
• Perpetual
• Average Cost

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Choosing a Method

• Consider the following factors
• Tax consequences
• Industry norms
• Bookkeeping costs
• Management incentives
• Signaling to financial markets

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Valuation Consequences

• LIFO may signal better cash flow prospects.
• Because LIFO helps to delay taxes, a cash flow
  benefit would be rewarded by markets.
• However, because LIFO reduces accounting income,
  debt covenants may be violated causing negative
  market reaction.

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LIFO and Financial Statements

• If purchase prices fall at the end of the period
  management could strategically make purchases at
  the end of the period to reduce COGS.
• LIFO liquidation- when more inventory is sold in
  the period than was purchased.
• Inventory layers from previous periods with low
  costs will be depleted (rising costs) and profits
  will look higher.
• For comparison purposes, firms using LIFO are
  required to footnote current inventory values.

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Ratio Impact

• Firms who have been using LIFO for a long period
  of time may find their inventory ratios are
  difficult to interpret.
• Balance Sheet levels of inventory do not match
  with the inventory costs charged to COGS.
• Use instead LIFO COGS
• Average FIFO inventory
• Differences between LIFO and FIFO are higher when
  the LIFO reserve is large.